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Property investing meets FIRE

By Victor, The Frugal Samuari

Chapter 20 of Aussie FIRE, a collaboration between 20 of Australia's top FIRE experts

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The beautiful thing about FIRE is that there are many ways to achieve it.

Many of us go down the tried and tested passive investing route with ETFs and LICs.

But for those of you who wanted a bit more of a hands-on approach to achieve financial success, investing in real estate can be equally if not more rewarding on the financial journey. It’s what I usually blog about over at thefrugalsamurai.com – simply because I can’t get enough of it!

Don’t just take it from me though! The latest Australian Taxation Office data shows that there are over 2 million landlords in Australia and residential real estate accounting for more than half of all household wealth.

In this chapter, I’m here to run through what is real estate investing, how it works, the different types of real estate investing, the different strategies, and lots more. All of the sections include:

Introduction

Real estate investing in Australia is a unique and oftentimes rewarding pastime mainly because us Aussies, we love real estate.

It is so culturally ingrained into our psyches, that the “Great Australian Dream” of homeownership even has its own Wiki page!

“The Australian Dream or Great Australian Dream is a belief that in Australia, homeownership can lead to a better life and is an expression of success and security”.

The chase for this dream, has led property prices to rise, and rise, and rise some more.

In fact, the chart below shows the historical return of the major cities in Australia.

 

Graph of median house price by city in Australia from March 1980 to September 2016


Look at those returns!

I can just see the gold coins flashing before my eyes. And all that through quite a number of financial shakeups.

And if you were wondering what the historical return of properties versus shares has been, take a look at this chart below:

Graph of long-term asset class returns in Australia from 1980 to 2016

 

Not too shabby right!

So what next? Should we just go out and buy the first property we see?

Well no… because the first thing we should be doing is…

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Plan

Every journey starts with a plan, and investing in real estate is no different.

But how?

One way I approach planning is to have the end in mind, and then work backwards.

For example, many people are targeting a “magic number” in terms of passive income.

A commonly cited figure is $100,000 p.a.

Assuming a 5% return, you will need $2 million in real estate assets to get you there.

Strewth - $2 million! That’s a pretty big figure.

Well, to be honest, residential property has actually far outperformed 5% historically. This is because the returns from real estate take the two forms; capital growth and rental yield.

Combine these two together, and real estate has performed pretty much in line with shares over the ages.

Graph of return on investment of $100 in 1926 from various long-term asset classes


The figures above don’t factor in the costs of holding property nor the leveraged property investing allows - but even still, a net return of 5% is a realistic number to aim for.

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What to invest in

So, you’ve figured out your magic number, and you know what you need to take you there – but what should we buy?

There are two main types of real estate, being:

  1. Residential Real estate – this one is the most common with the least barrier to entry to normal folk like you and I. Think a standard house or apartment/unit.
  2. Commercial Real estate – this is a bit more specialized as you are buying into retail (e.g. shop/café), office (e.g. um, offices) and industrial (factory warehouses and units) types of property. Commercial real estate is generally riskier and not recommended for the novice investor.

For the purposes of this chapter, the focus is on the most common type: residential real estate.

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Property investing strategies

You might have heard of the terms “negative gearing” or “positive gearing.”

Are these strategies?

Not quite.

You see, whether positive or negative gearing, they are just a reflection of a point in time.

Negative gearing means the expenses of holding your investment is higher than the amount of rent it is bringing in, with the hope that the capital gains is higher than the difference.

Positive gearing is when the income generated (rent) is higher than the expenses.

But these aren’t strategies, they are tax outcomes.

No, real strategies are more like:

Buy and hold

As the name suggests, involves buying and holding for the long-term. This way you are sitting on your investment in the hope for capital gains over the long-run. There is usually a more ongoing, and predictable income in the form of rent (beware the vacancies!) and lower transaction costs. Although your money is tied up longer as it may be many years before you see lip-smacking returns.

Add Equity

The beauty with real estate investing is that you can add value to your investment. You can’t do that with a stock or ETF. Renovating is a great way to manufacture equity and artificially create value. TV shows like “The Block” or “House Rules” has popularized the renovation concepts to the mainstream. A fresh lick of paint or an updated kitchen and bathroom will do wonders to the valuation of your property. But beware to not over-capitalize, a rule of thumb is generally $2 added for every $1 spent.

Subdivision/Development

This is where the serious money is made, and also where there are enormous risks. Subdividing and developing is where you are creating something from scratch. Be it in the form of subdividing a block from 1 into 2, or building another dwelling on your property (dual occupancy), to building a whole row of townhouses. There are many, many moving parts with this strategy so it is imperative that you have experience behind you and not bite off more than you can chew.

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How to structure your investments?

When I first started, no one showed me the different ways to structure your investments – so I’ve had to learn the hard way.

I suppose that’s what an accountant is for right? Please seek professional advice for anything personally tailored for yourself, however, the below are the three general structures property investing is held in.

Individual

The easiest and simplest option.

Holding investments in individual names allows you to utilize negative gearing against your other incomes. However, there is minimal asset protection in the event of litigation, and you are taxed at your marginal rate should you decide to sell your asset (CGT discount is available after 12 months though).

Company

A company is a separate legal entity, which provides some form of asset protection. The corporate tax rate is a flat 30% (27.5% in some instances), but there is no negative gearing available. Any losses are trapped in the company and can only be offset by future gains. There is no CGT discount also.

Trust

A trust entity is an entity whereby a trustee looks after the trust’s assets for the benefit of the beneficiaries. Um… a simple way to explain it is to think of driving a car. The trust is the vehicle itself. The driver (you) is the trustee, you control the action. The kids in the back seat (yours) are the beneficiaries, gotta look after those precious babies. A trust provides flexibility in distributing income, and there is the CGT discount available. However, any negative gearing losses can only be offset against income within the trust.

There are pros and cons to each entity people! So please seek professional advice for which one is best suited for you – don’t just rely on a faceless guy called The Frugal Samurai. Hey, that rhymes!

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What to buy & what to avoid

Ah yes, the all-important question.

There’s no right or wrong answer here, as it depends on your strategy of course.

But here’s the type of property that I am constantly on the look-out for:

High land-to-asset ratio

Land, no one is making any more of it. Typically, land appreciates and buildings depreciate, so the land component is what drives the growth of your investment. That doesn’t necessarily mean a larger block of land, but one in which the value of the land makes up the significant part of the asset value.

Below intrinsic value

Part of the reason why I love real estate is that you are able to negotiate directly with the seller, you can’t offer 20% off BHP shares or 15% off CBA shares – but you can make any offer you want when buying a property (whether it’s accepted is another thing). Sometimes you can nab a real bargain and make good money on the way in.

With a twist

There has to be something unique or special about the property – a water-view or a slightly larger courtyard for example. This will differentiate the property from the others on the market, as well be reflected with a slightly higher valuation with comparables.

Add Equity

Typically, I do not like buying new, because you are paying a developer’s premium when you do. I like to manufacture capital growth through small refurbishments or renovations rather than waiting for the market to do its thang.

Demographics

The all elusive “gentrification” of a suburb, the key is to get in before it starts to gentrify, which is easier said than done. But many fellow investors have done very well with buying into ugly duckling suburbs.

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Property Management

This is probably one of the main reasons’ investors are turned off from investing in real estate.

It probably explains why 71% of the 2.15m landlords have only 1 property, and why only 20,000 people have more than 6.

With all the added costs and time commitments such as council and water bills, insurance bills, land tax bills, property management costs, repairs and maintenance costs – it’s no wonder some investors are looking to sell up.

But like any serious investor – we should be treating real estate investing as a business, not as a hobby. You’ll find that if you have a good property manager, the time commitment is reduced substantially.

"We should be treating real estate investing as a business, not as a hobby." -Victor, The Frugal Samurai

Unfortunately, there’s not much you can do with upkeep and maintenance costs, nor the various bills involved, but again a good property manager should be helping you to take care of these things.

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Rent vs Buy primary residence

This is a very common question, should I rent or buy a place to live?

“Rent money is dead money” is a common argument against renting. But is it? Let’s have a look at the pros and cons of each:

Pros of renting:

  • In some cases, the rent is often cheaper than mortgage repayments on the same property.
  • There is no large commitment (mortgage debt) that you owe.
  • In residential leases, the landlord pays for the outgoings such as rates and strata fees; they are also responsible for the repairs.
  • Flexibility of moving to another location if and when you choose (provided it’s outside a fixed lease).

Cons of renting:

  • Your hard-earned money is helping to pay off someone else’s mortgage.
  • You are at the whim of the landlord; they can move in or evict you if they want to put the property up for sale.
  • Similarly, you are reliant on the landlord to carry out repairs and maintenance in a timely manner. You also cannot make any major changes to the property.
  • Rent can increase over time.

Pros of buying:

  • You own your own home!
  • Each loan repayment builds up your equity position
  • You can personalize your own place as you see fit
  • Optionality, a lot of people have turned their homes into investment properties down the track

Cons of buying:

  • The mortgage is a very large financial commitment; probably the biggest purchase you and I will ever make.
  • Saving a deposit can be HARD.
  • Those pesky interest charges, means the banks are laughing all the way to… the bank.
  • Volatility, we are at the whim of the housing market.

So, what’s the conclusion?

Well, rent money is dead money – because you will never be able to get it back, at the end of the day you do not own anything.

But buying a property usually means a mortgage, and there is a reason they are over 30 years – that’s the bulk of our working lives gone just to service one loan. Not to mention the other costs involved when buying a property.

Aw but then again, a place to call your own and grow roots doesn’t sound too bad does it?

I’ll sit on the fence here because it’s impossible to confidently state which one is better over the other, there are way too many factors involved – it all comes down to your life goals and financial position.

But here is a summary table to make it easier for you:

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Renting & Investing In Shares Vs Buying A Home

Pros of renting whilst investing in shares:

If the rent is cheaper than mortgage repayments, you can use that free cash flow to participate in gains in the share market.

You also receive income from your investment portfolio which you can use to buy more assets.

There is also the option of not being tied down into such a large commitment and your lifestyle arrangements remain flexible.

Cons of renting whilst investing in shares:

“Rent money is dead money”. Your money is paying off someone else’s mortgage.

The share market is traditionally more volatile than property, which means the value of your investment can drop suddenly.

You are at the whim of the landlord.

Pros of buying a home:

You own where you live.

There is typically more leverage afforded to home loans, meaning you can build up equity quicker.

Each time you make a repayment, you artificially create equity.

Cons of buying a home:

The mortgage is a substantial expense for a very long time.

Saving for a deposit is also extremely prohibitive.

If interest rates rise, your loan repayments increase.


Risks with real estate

Like any investment, there are risks involved with real estate. Although generally deemed less risky than shares, it is imperative to evaluate the risk of any investment. In this section I’ll walk through the main risks you should be aware of:

  • Illiquidity | Property is not liquid, which means your money is tied up in the investment. If “touch wood”, something befalls you, it is not a simple case of selling your investment and withdrawing your money. It takes a long time to transact.
  • Interest Rates | We are fortunate to be in a position in recent memory that the RBA has been cutting rates like no tomorrow (literally), this means that many younger generations have not experienced rising interest rates and hence rising mortgage repayments.
  • Market Forces | Like any investment class, property is still subject to market factors such as supply and demand, consumer sentiments, creditability factors which affect the value of the asset.
  • Vacancies | Just because you own property doesn’t mean it will always be tenanted. Be prepared for those periods where you don’t have one, as this means no income is coming in… but the expenses still add up.

The A-team

If you’re the smartest guy in the room you’re in trouble – because, like any great investor, you should have a great team around you. Here’s your A-team:

  • Accountant | Absolutely crucial to have an accountant on your FIRE journey who understands what you are trying to achieve. Here in Australia, we have one of the highest tax systems in the world – so it’s paramount to get your taxes sorted out correctly.
  • Broker/lender | Property investment is a game of finance. If you want to take it seriously, you have to build up a portfolio. This is where having a mortgage broker or home lender is vital to review your portfolio on a regular basis and set you up for the next purchase or three.
  • Solicitor/conveyancer | When was the last time you read through a legal contract? Yep, never is the answer for me too. Having an experienced solicitor and/or conveyancer is worth their weight in gold. When you are dealing in six, sometimes seven digits – mistakes are extremely costly, waste time and downright are stressful, protect yourself against them!
  • Property Manager | An unsung hero on any team, but a good property manager is invaluable. They source the best tenants, conduct the application process and make sure your best interests are protected. Oh, and they also manage any property maintenance and repairs, to make your life much EASIER.

There are other benchwarmers on the team, of course, real estate agents, insurance specialists, buyer’s agents (if you’re time poor), but at the end of the day – don’t do it alone!

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Alternatives

As the real estate market evolves so do different alternative ways to invest in real estate, some of these are:

  • Fractional Real estate – fractional investing (or crowdfunding) is a relatively new phenomenon in Australia. As the rise in property values has priced many people out of the market, pooling everyone’s funds together allow us to each hold a slice (fraction) of ownership into these markets. BRICKX and DomaCom are the two main platforms in Australia.
  • A-REITs – which stand for Australian Real Estate Investment Trusts. These are ASX publicly-listed companies that pool investor funds much like a managed fund. Instead of buying shares, an AREIT purchases and manages a portfolio of typically commercial properties.
  • Property stocks – just like any other sector, there is a real estate sector on the ASX, which holds about 80 individual companies. They are usually either property developers (Mirvac, Lend Lease), or commercial landlords (Scentre Group, Stockland, Dexus).
  • Mortgage Trusts – this is more the domain of the larger players and more sophisticated investors – usually in the tens if not hundreds of millions of dollars. One day!

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Personally

In case you haven’t realized, I am a big advocate of real estate investing.

MrsFrugalSamurai and I currently hold eight properties in our portfolio, and we are positively EXCITED for the future with how it can help us to FIRE!

If you liked this chapter, head over to thefrugalsamurai.com as I go a bit more in-depth into the sections covered.

Finally, I’d like to say that I wish I had a resource like this when I first started my journey – the path is so much easier when it’s been walked on before.

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About Victor from The Frugal Samurai | thefrugalsamurai.com

Hi, I’m Victor, a 30-something millennial from Sydney, Australia. Growing up, no one showed me how to attain wealth so I’ve had to teach myself the hard way. I share my journey to being financially independent at thefrugalsamurai.com – I typically focus on investing, personal finance and development as well as commenting on topical financial issues. I’ve worked in the financial industry for over 13 years (and counting) and this allows me a unique perspective as a fly on the wall

 


 

At Pearler, we pride ourselves on the quality of the financial advice we give. Please note though, that this advice has not been tailored for you. You have unique financial goals, circumstances and needs which may make this advice inappropriate, and it is important that you know whether it applies to you. If you are unsure we urge you to speak to someone you trust who is competent with money and understands your individual needs, whether they be a trusted friend or professional.

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